Let's Get Real.
The economy is on fire, unemployment continues to fall, and wages are growing the fastest in two decades. Yet despite this strength, it appears that the only thing on investors’ minds these days is inflation.
There’s some merit to this concern for two reasons. First, inflation is at a 30-year high, but that’s only the tip of the iceberg. Take the 6.2% annualized inflation rate1 and compare it to wage growth at 4.9%2, and workers are losing purchasing power (4.9% – 6.2% = -1.3%).
The chart below shows that this problem has been around for several months. When the orange line is above the blue line, “real” wealth is created (that’s good). But when the blue line is above the orange, purchasing power is eroded (that’s bad).
As the saying goes, it’s not how much you earn but rather how much you keep. Inflation is a tax, so workers are now seeing less after “taxes.”
Second, inflation taxes consumers differently, so broad measures of inflation are often too broad. For example, I’m in my late-30s with two young daughters. My expense structure looks vastly different than a retiree who spends less money on gas and Disney's Frozen toys and more on medical expenses. I’d wager a lot of Americans are experiencing inflation way higher than 6.2%.
Consumers appear to be worried. U.S. consumer confidence plunged to a 10-year low in November thanks to inflation4. However, inflation does not appear to be a major risk just yet for two reasons.
First, the American consumer is doing well right now. The government sent checks in the mail for over a year, which allowed consumers to pay down high interest debts and increase savings. Today, trillions in cash remain in bank accounts and likely act as a psychological buffer against rising prices. Recent retail sales data soaring well above already lofty expectations offers even more evidence to this point5.
Second, there is little data that suggests consumers expect inflation will last. If consumers were truly worried about sustained inflation, they would be hoarding and spending more in categories hit hardest by inflation for fear of even higher price hikes in the future.
But the chart below shows that the exact opposite appears to be happening. Since prices began rising earlier this year, inflation-adjusted consumer spending on major durable goods and housing has plunged. This phenomenon suggests that even though consumers are worried about inflation today, they appear to be waiting to buy many of these goods. Perhaps this is because they expect prices to normalize relatively soon.
The Bottom Line
Gun to the back of my head and I’d say that inflation recedes a year from now but doesn’t go back to pre-COVID either. The chart below separates inflation into two groups – those categories that have been hit hard by the pandemic (blue) and those that have not (red). The categories represented by the red columns constitute most of consumer spending, and as the chart indicates, they have not varied all that much in 2021. In fact, they explain only 38% of the total increase in inflation this year.
The categories represented by the blue columns are the ones that experienced rapid price increases due to the pandemic and supply chain disruptions. These only account for 30% of spending, yet they explain over 60% of the total increase in inflation6. Meaning, a small percentage of categories is fueling most of the inflation.
The good news is that we are starting to see early indicators of improvement for the blue categories. The government is no longer paying people to stay at home, so jobs in key industries like transportation are starting to get filled. That’s a very good first step to alleviating some of the supply chain pressures through the first half of next year.
Furthermore, technology continues to push down prices, and it’s hard to imagine the innovation driving artificial intelligence, cloud computing, inventory management, logistics, and so many other technological advancements drying up anytime soon. If anything, expect this deflationary force to strengthen over time.
However, not all inflation is supply chain related. The chart below shows that the money supply is 40% higher than pre-COVID, and unless the government has plans to take all this money out of the system, which they don’t and won’t, some of this inflation is here to stay.
If so, then it’s important to protect against this tax. Historically, here are the asset classes that have performed the best and worst on an inflation-adjusted (“real”) basis.
Stocks topping the list makes a lot of sense. Companies with pricing power can pass along cost increases to customers and preserve profitability. Real estate (REITs) also makes sense for those subsectors that can renegotiate leases more frequently.
At the bottom of the list are fixed income streams (bonds and cash) and assets that produce nothing (gold and other commodities). When it comes to bitcoin and other cryptocurrencies, only time will tell how they stand up.
Let’s see what could happen if I’m wrong and inflation remains high. Here’s the table for all years when inflation exceeded 4%. Although this has only happened in 8 of the last 45 years, the trend appears to be intact.
Lastly, neither table is suggesting to sell all bonds and gold and pile into REITs and stocks. Extreme moves like that typically lead to extreme outcomes, and that sort of risk isn’t palatable for most investors. Instead, it’s meant to help inform a more diversified approach and fuel better conversations with us - especially if you’re sitting in excess cash.
The bottom line is that inflation is here, and although it’s likely to moderate at some point, that doesn’t imply it’s going away. The good news is that you can usually invest to protect against inflation without a lot of fancy maneuvering.
3 The Federal Reserve Bank
This newsletter/commentary should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.